Module -2

Equilibrium Price
• The Equilibrium price of a commodity is the
price at which demand equals supply , i.e at
a given price, same quantity is demanded
and supplied. This quantity is called
Equilibrium Quantity.
 D S
Price

P Equilibrium Point

S D
O
M
Quantity Demanded and supplied

• In terms of the diagram shown, equilibrium price of a commodity

is the point of intersection of demand and supply curves.
• OP is the equilibrium price and OM is equilibrium quantity
demanded and supplied.
The concept of equilibrium price can be better
understood with the help of following
illustrations.
Per Unit price Quantity Quantity Description
(Rupees) Demanded Supplied
(Units) (Units)
10 5000 3000 Excess Demand
20 8000 5000 Excess Demand
30 6000 4000 Excess demand
40 9000 9000 Demand = Supply
50 7000 11000 Excess Supply
60 5000 13000 Excess Supply
 Production
• Production is the conversion of Input into
output.
• In economics the term production may be
defined as creation of value, which can be of
two varieties namely use value and
exchange value.
• Thus , Production is the activity which
creates or adds utility and value.
 Factors of Production
• The resources which are used for the
production of a thing are called the factors of
production or the agents of production.
• The factors of production and all other things
which the producer buys to carry out
production are called input.
• The final goods and services produced are
knowns as output.
• The factors of production have been
traditionally classifies as :

 Land
 Labour
 Capital
Land:
It represents all the gifts of nature., including soil ,hidden resources,
mountains forests, air, rain, light etc. Therefore land represents everything
which is not made by man. It provides platform for human action.

Labour:
In economics , the term labour includes the work done by human beings
only.in this sense a musician who sings for pleasure or a mother who looks
after her children is not a labour.

Capital:
Capital is the produced means of production. Capital stands for assets
available for use in the production of further assets. Capital is wealth in the
form of money or property owned by a person or business and human
resources of economic value.
 Theory of Production
• Production is a process of converting an input into a more
valuable output.
• The analysis of demand is mainly used for planning the
production process and determining the level of production.
Production is an aspect of the seller side of the market.
• Theory of production basically determines how the producer
given the state of technology combines various inputs
economically to produce a definite amount of output in an
efficient manner.

Labour Goods
Material Transformation and
Equipment Process Services
Capital
 Production Function
• The functional relationship between input and output is known as production functions.
• It state the maximum quantity of output which can be produced from any selected
combinations of inputs.
• The production function can be expressed in form of an equation in which

 output is the dependent variable and

 Inputs are the independent variables.

The equation is expressed as follows

• Qx= f (L,K,T,….n)

; Where Qx= Output

L = Labour
K = Capital
T = level of technology
n = other inputs employed in production.
 Production Analysis
• Production analysis basically is concerned with the
analysis in which the resources such as land, labour
and capital are employed to produce a firms final
products.
• To produce these goods the basic inputs are
classified into two divisions.
• 1. Variable inputs: inputs those change or are
variable in the short run or long run are variable
inputs.
• 2. Fixed inputs: An input for which the level of
usage cannot readily be changed.
 Time horizon of analysis
Two different time periods are used to develop
theories of production and production costs.
• 1.Short run: The period of time in which
labour and material can be changed, but all
inputs cannot be changed simultaneously.
Especially equipment and machinery cannot
be fully modified or increased.
• 2.Long run: Long run is defined as that time
period over which a firm can vary quantities of
all factors of production.
 The law of variable proportions/
Short run production function

The law of variable proportion is the modern approach to

the Law of Diminishing Returns (or The Law of Returns).
The law of variable proportion shows the production
function with one input factor variable while keeping the
other input factors constant.
In other words it states that , if one factor is used more
and more (Variable), keeping the other factors constant,
the total output will increase at an increasing rate in the
beginning and then at a diminishing rate and eventually
decreases provided there is no change in technology.
 Returns to a Factor
• The return to a factor is the relationship
between output and variation in one input
while keeping the other factor inputs
constant. The relationship is also known as
productivity of a factor of production.
• Factor productivities are of three types viz:
 Total Product
 Average Product
 Marginal Product
 Total Product (TP) :
Total product is the total quantity of output a firm obtains from a given
quantity of that factor input., while all the other factors are constant.

 Average product (AP):

Average product is the output produced per unit of input. The average
product of a factor of production is the total product of that factor divided by
the quantity of that factor while all the remaining factors are held constant.
AP land = TP/ L ; AP capital = TP/K

 Marginal Product (MP):

It is the change in Total Product that results from a one unit increase in that
factor of production , keeping all other inputs constant.
MP = TPn- TPn-1
Where TPn is the Total product of n products,
TPn- 1 is the Total Product of n-1 products.
Table below shows the different output levels of a particular
commodity for various combinations of two inputs Labour ( L) and
Capital (K)

Q= 20 Q=44 Q=75 Q=100 Q=110

L K L K L K L K L K

1 10 2 10 3 10 4 10 5 10

2 6 3 7 4 7 5 8 6 8

3 4 4 5 5 5 6 6 7 7

4 2 5 3 6 4 7 5 8 6

8 1 6 2 10 3 10 4 10 5
From the table above ,we can draw another table for five different
output levels of a particular commodity keeping one factor say K,
keeping constant.

Labour TP L AP L MP L
1 20 20 -

2 44 22 24

3 75 25 31

4 100 25 25

5 110 22 10
 Returns to Scale/
Long run production function

Law of returns to scale is a long run concept .

• A return to scale is the rate at which the output increases with the increase in all inputs proportionately.
There are three cases to return to scale.

• 1. Increasing returns to scale:

When inputs are increased in a given proportion and output increases in a greater proportion, the
returns to scale are said to be increasing.
E.g if inputs are increased by 40% and output increased by 50%.

• 2. Constant return to scale:

When inputs are increased in a given proportion and output increases in the same proportion, the
returns to scale is said to constant.
E.g if inputs are increased by 40% and output also increase by 40 %.

• 3. Decreasing returns to scale:

If a proportionate increase in all inputs results in less than proportionate increase in output, the return to
scale is said to be decreasing.
E.g if inputs ae increased by 40% but output increases by only 30%.
The following numerical illustration explain the concept of Return to Scale.

Units of Units of Total % change % change Returns to

capital Labour Output in input in Output Scale

20 150 3000 - - -

40 300 7500 100 150 increasing

60 450 12000 50 60 Increasing

80 600 16000 33 33 Constant

100 750 18000 25 13 Decreasing

 
Cobb Douglas Function
The two inputs used by the authors were number or manual workers (L)
and fixed capital (K). The cobb Douglas production function describes the real
output in monetary terms as under:

Q=AX X

: Where L = Labour
K = Capital
A = Total Factor productivity
a = Output elasticity of Labour and
b = Out put elasticity of Capital
It can mathematically be seen as the total real output per unit of the geometric
weighted average of the inputs

A=Q/
 

The sum of the two output elasticities determine the behavior of output to
variations in inputs. Having said that if:

a + b = 1 the returns to scale are constant

a + b > 1 the returns to scale are increasing
a + b < 1 the returns to scale are decreasing

This can be understood mathematically. Rewriting the cobb Douglas production

function we get,

Q=A

Let the two inputs, labour and capital be increased to two times, i.e double
their value. The function will then become
Q’ = A (2 X (2
= A
= A
= A
=Q
The returns to scale will be constant if due to the doubling of the
inputs , the output also doubles, i. e Q’ = 2Q. This can be seen to
happen in the above equation when a + b = 1. Like wise the returns will
be increasing if the output increases more than proportionate to the
rise in inputs and in this case Q’ > 2Q, i. e a + b > 1, and with the same
reasoning decreasing if Q’ < 2Q i. e. a + b < l